'A terrible environment for equities': Market veteran predicts when stocks will pull back — and how to trade it

Published Thu, Mar 9 202312:49 AM EST

The U.S. equity market is flashing warning signs, according to chief market strategist Chris Watling. Watling, also the chief executive of London-based Longview Economics , expects stocks to fall into a bear market over the next three to six months thanks to lofty valuations driven higher since September last year. The S & P 500 was trading at 3,985 on Wednesday morning at a price-to-earnings ratio of nearly 20x even as the U.S. central bank attempts to tighten financial conditions. According to Watling, valuations are now in "bubble" territory and have never been so high except during the dot-com and pandemic-era boom in stock prices. "You've got a market here on a forward P/E ratio of 18 and a half times, which has only really been substantially higher in a bubble," Watling told CNBC's "Squawk Box Europe." "It's a terrible environment for equities," he added. When asked about a potential fall, Watling said investors should be cautious because if the S & P 500 earnings reverted to its historical mean, the benchmark could decline by 900 points – a drop of nearly 25% from current levels. "If you say that the [S & P 500] forward earnings should be 200, and you say that average multiple is 15 times, you get to a number of about 3000," Watling said. .SPX 1Y line While investors may be tempted to stay in the market due to a lack of better options, Watling suggests otherwise. "If you want to make money, you should be short equities over the three to six-month timeframe," he said. "You should be overweight government bonds, should probably have a little bit in cash, and there's certain commodities you should be playing, most likely the precious metals." He cautioned, however, that this strategy is very aggressive and unsuitable for the average investor. Watling advised that investors should make diversified bets and not bet the house on one investment. Stocks have risen over the past five months partly in response to a lack of distress in the high-yield bond market. Instead, for example, the difference in interest for bonds issued by junk-rated U.S. companies and U.S. government bonds has fallen from 3 percentage points at the start of this year to 2.6 percentage points, according to the Federal Reserve Bank of St. Louis. This seems to be defying credit conditions wanted by the Federal Reserve, and Watling suggests it could be a short-term liquidity story driving the market. Watling said the recent increase in central bank balance sheets globally since October is due to China reopening, the Bank of Japan printing money, and the Treasury general reserve account releasing liquidity to offset the Federal Reserve's quantitative tightening program. "It may well be just a short-term liquidity story that seems to have dislocated the spreads from what credit conditions are telling you," he added.